EC741 Public Economics Handout 12: Fiscal and Regulatory Relationships Among Governments
I. Federalism as a Form of Polycentric Governance
a. For example, in some cases a subset of local officials are appointed by higher
levels of government.
b. In other cases, local governments have relatively little ability to make tax,
expenditure, or regulatory decisions.
A. Thus far in the course, we have analyzed:
i. the positive properties of a single tax or expenditure program in
isolation
ii. the normative properties of such taxes and expenditures
iii. the normative or "economic" case for government services and
regulation: externalities and public goods problems
iv. and, the politics the underlie the main (large and well known) tax and
expenditure programs selected by elected governments.
v. All these analyses were grounded in relatively simple and general
models of rational decision making.
iii. The parliaments of most federal governments include a chamber that
represents state (provincial, lander, etc.) interests.
w Some political scientists insist that a truly federal government always have a
chamber in the national legislature that represents state interests.
w However, such a structure is not necessary for what economists refer to as
“fiscal federalism.”
w What is required for fiscal federalism is simply some local independence
and some authority to make fiscal (tax and/or spending) decisions.
B. We now turn to settings in which governments are not monolithic
unitary organizations, but rather decentralized, federal, or confederal
governments.
i. Such policy making structures are common: within most countries,
there are regional and local governments, as well as central (national or
federal) governments.
II. Public Finance in Federal Systems
A. In cases in which several of the “levels” of government have
independent taxing and/or spending authority, a country or nation state
can be said to exhibit fiscal federalism (Oates 1972, 1977, 1999; see
also Mueller in Congleton and Swedenborg 2006).
i. Fiscal federalism does not require political federalism in the sense of a
national senate, but it does require “polycentric” decentralized
governance (Ostrom 1972, McGinnis 1999, Hooghe and Marks 2003).
{ For example, within the US, there are national (federal), state, county,
and town governments. Similar divisions exist in most countries.
ii. In most cases, the rules of the central government constrain the
authority of the regional and local governments.
iii. Nonetheless, in cases in which the various governments are
independently elected--rather than appointed by the central
government in some way--and the local governments have significant
control over local fiscal and regulatory policy, the result is a
decentralized, “polycentric” system of governance.
a. Within the US, individual state, county and town governments (local voters)
can usually control local taxes and expenditures.
b. Similar decentralized control over taxes and expenditures also exist in
Canada, Australia and Switzerland.
ii. The greater is the independence of local governments and the broader
is their fiscal and regulatory authority, the more decentralized is a
federal (or other polycentric) government.
iii. In other less decentralized federal systems, control over many local
taxes and expenditures is exercised by higher levels of governments.
C. In federal systems of governance, the central government is formally
sovereign, rather than the “member” states, but the states have
independent formal legal (constitutional) status.
i. Federal states, thus, include a hierarchy of governments with more or
less overlapping jurisdictions, but more or less independent policy
making procedures.
ii. Some federal systems are more decentralized than others, because their
local governments are less independent and/or have less authority than
in others.
a. Independent state and local governments exist, but they are not able to set
many (or any) local tax rates or may have very limited control over local
expenditures.
b. Fiscal federalism exists in such countries as well, if local governments can
make some independent fiscal decisions.
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EC741 Public Economics Handout 12: Fiscal and Regulatory Relationships Among Governments
C. Among the vertical relationships given most attention by economists
are intergovernmental grants and political feedbacks.
i. One important strand of state and local public finance explores the
effects of "intergovernmental grants" on state and local policy choices.
iv. Within "unified" governments, local governments may also be more or
less independent and more or less free to determine taxes,
expenditures, borrowing, and regulations.
w Such states may be considered to be "federal" in the fiscal sense because
taxing and/or spending authority is distributed between national, state, and
local governments.)
w Illustration of the effect of an intergovernmental grant on local
expenditures.
ii. Another concerns the political effects that "states" have on higher
levels of government, insofar as state voters and their representatives
have "regional" rather than national interests (See Knight in Congleton
and Swedenborg 2006).
Figure 1: Levels of Government
Central Government
a. The existence of intergovernmental grants and targeted grants tend to induce
local and state governments to lobby in favor of such programs.
b. One possible result is "Pork barrel politics" a.k.a. the "fiscal commons
problem" (discussed below).
Intergovernmental Grants
Regional (State) Gov. 1
Local Gov A
Local Gov B
Local Gov C
Regional (State) Gov. 2
Local Gov D
iii. Still another concerns how bargaining between levels of government
affect the extent of centralization observed (Congleton, Bacaarria, and
Kyriacou 2003).
iv. In addition to the vertical relationships, there are several “horizontal”
relationships that are of interest to economists.
Local Gov E
a. For example, to the extent that "tax base" is mobile across local
governmental jurisdictions, intergovernmental competition over taxes,
expenditures, and regulation tends to emerge.
{ If community A has higher taxes than Community C, people from
community A will tend to move to community C--unless the services in
community B are noticeably better than those in community C.
{ (The effects of competition between government are discussed below.)
b. There are also regulatory externalities that tend to be associated with local
governments.
B. Federal systems of governance have both “vertical” and “horizontal”
relationships among governments.
i. With respect to “vertical” relationships: some services and taxes may
simply be mandated by higher levels of government.
a. Local governments are constrained in what they can do by state laws.
b. State governments are constrained in what the can do by national laws.
c. In the diagram above, the red arrows can be thought of as "mandates" placed
on local governments and/or as grants (subsidies) paid to local governments.
D. The economics and politics of these fiscal relationships not only allow
us to understand federal governments operate but also help us analyze
how federal systems should be designed.
ii. In addition to mandates and prohibitions from higher levels of
government, there are often subsidies from "upper" levels of
governments to "lower" levels of governments that create new
opportunities for local governments to provide services without having
to raise local taxes.
III. The Effects of Intergovernmental Grants
A. Modeling the effects of intergovernmental grants requires a model of
local governmental decision making (Bradford and Oates 1971, Romer
and Rosenthal 1980, Gramlich 1998).
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EC741 Public Economics Handout 12: Fiscal and Regulatory Relationships Among Governments
b. (Add indifference curves to diagrams like that above, and analyze how different
kinds of grants tend to affect the level and distribution of government services
within a community.)
i. Within democracies, these can be based on the median voter model,
perhaps augmented by the effects of interest groups and
intergovernmental competition (see below).
ii. The median voter model ( and median legislator model and governor
models) allow the decisions of government to be modeled as if they
were made by a single person.
iii. This, in turn, allows us to use diagrams from microeconomics to
represent the effects of conditional and unconditional grants on local
governments.
iv. For the most part, the empirical evidence on the effects of grants is
consistent with such one person (median voter) models of government
decision making.
v. There is however one puzzle, often termed the "fly paper effect"
(Hamilton 1983, Bailey and Connolly 1998, Jacoby 2002).
a. Block grants, which resemble lump sum grants, increase government services
by more than one would expect based on standard consumer models.
b. The grants "stick" to the programs they are aimed at, rather than inducing
tax reductions that the median voter model seems to predict.
B. The median voter and intergovernmental grants.
i. As was the case for ordinary subsidies, intergovernmental grants can be
"lump sum" or "marginal" (block grants or matching grants).
{ That is to say, in a community that spends 10% of its income on government
services why aren't 90% of block grants used to reduce taxes?
w As true of ordinary subsidies, grants may also be conditional or not.
{ (There are several theories that can be used to explain this, but all require
more complex models of governance than our simple median voter
model, and not all are very convincing.)
ii. Both conditional and unconditional matching grants affect relative
prices of alternative government services.
w Both conditional and unconditional block grants have income effects but
not relative price effects.
IV. The Pork Barrel Dilemma
A. The existence of intergovernmental grants creates incentives for state
and local governments (and state representatives and senators) to lobby
for programs that benefit their own states--even if they do not benefit
the nation as a whole.
i. The federal government funds specific highway and water projects that
benefit only a particular city or metropolitan area, but which are paid
for by taxes imposed on everyone in the country.
The Median Voter's Allocation Problem
G2
Lump Sum Grant
T/Pg2
(Draw in the Median Voter's
indifference curves to see the
effects of these grants.)
Conditional Lump Sum Grant
No Grant Circumstance
a. Programs that often have regional rather than national benefits include: flood
insurance, hurricane relief, ports and harbor spending, railroad and airport
subsidies.
b. Many highway and irrigation projects, national parks, and museums also
mainly produce local benefits.
Matching Grant
T/Pg1
G1
Gov Service 1
ii. Groups will press for targeted projects that generate benefits for them that are lower
than their own tax costs.
iii. How intergovernmental grants change the public budget constraint is
illustrated above. How such grants affect public policy require adding
the indifference curves of the "pivotal policy maker."
a. Such targeted programs (ear marks) can lead to inefficient policies at the
national level, because central government expenditures are normally funded with
general revenues.
a. For most of our purpose the relevant indifference curves are those of the
median voter (or directly elected city planner).
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EC741 Public Economics Handout 12: Fiscal and Regulatory Relationships Among Governments
b. In such cases, the national funding of local projects induces a good deal more lobbying than
would occur if the projects were funded at local levels, because local benefits are more likely
to exceed local tax costs if other taxpayers are paying most of the cost.
the Pork Barrel Dilemma
Region B
iii. Most central government revenues are raised through broad-based
taxes, as with the income tax, corporate income tax, and sales (VAT)
tax.
Build Road
Don't Build Road
A, B
A, B
Build W
(-2, -3)
( +2, -4)
Don't build W
( -4, +1)
( 0, 0)
Region A
w This implies that the cost of targeted programs are spread over the nation
or state as a whole, even if benefits are only locally distributed.
iv. Adopting such targeted programs requires majority support within the
central government's legislature.
a. The payoffs to the region B and region A coalitions consist of their own
narrow benefits from their projects less half of the total cost of the projects
adopted.
a. Thus, not every possible project that has local support can be funded.
b. However, it is possible that a majority of voters (or legislators) receives net
benefits that are smaller than the costs imposed on the minority opposed to
the project or program of interest.
c. It is also possible for majority coalitions to be assembled for a group of
earmarks that have benefits that are smaller than their costs for the nation as
a whole.
d. This problem is sometimes called the "fiscal commons" problem or the
"pork barrel dilemma."
w If neither project is built, no benefits and no costs are realized.
w If just the road is built, then region A gets (1 - 10/5) = -4 in net benefits.
Region B, on the other hand pays its share of the costs and receives only
very small benefits (6 - 10/2) = +1.
w If just the water project is built, then region A gets most of the benefits but
pays only half the costs, (8 - 12/2) = +2. Region B gets its small benefit at
the cost of half of the water project, (2 - 12/2) = -4.
B. Illustration of the Pork Barrel Dilemma
i. Consider two programs with negative social net benefits, but majority
support from two narrow coalitions.
w If both projects are built, Region A gets (1-4) = -3 and region B gets (2 - 4)
= -2 in net benefits.
b. Each coalition has incentives to press for passage of their project, regardless
of what the other coalition does.
{ Notice that the payoffs in this case resemble those of a Prisoner's
dilemma game.
{ Each group has a dominant strategy
c. As a consequence, each project is adopted at the Nash equilibrium of
this game.
a. Each project has total costs that exceed its total benefits, but that regional
benefits are greater than regional costs under central government financing,
because of the use of general taxes.
b. For the purposes of illustration, assume:
w that a regional highway costs 10 billion dollars and provides 1 billion
dollars of benefits to region A and 6 billion dollars of benefits to region B.
w However, both coalitions would be better off if neither of the projects
were actually built!
w Assume also that a regional water project costs 12 billion dollars and
generates 8 billion dollars of benefits for region A, but only 2 billion dollars
of benefits for region B.
iii. The fiscal commons problem arises because of fiscal externalities. One
region's centrally funded programs impose costs on other regions, who
have to pay for those projects even though they receive little if any
benefit.
ii. The following game matrix can be used to illustrate this pork barrel
dilemma.
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EC741 Public Economics Handout 12: Fiscal and Regulatory Relationships Among Governments
w Note that prices are higher for consumers, lower for firms, and overall
market output is lower than in the untaxed setting.
iv. This problem can be avoided by (i) making the regions fund their own
projects, (ii) by rigorously using cost benefit analysis, or (iii) by
adopting a generality rule (see Buchanan and Congleton 1998).
w (Students should work this linear taxation problem out as an exercise.)
a. (Explain why these three solutions would all solve the dilemma.)
b. (Are there other solutions that would also avoid the PD outcome while
allowing projects with positive net benefits to be built? For example, how
might user fees or benefit taxes be applied?)
iv. A tax-revenue maximizing government (leviathan) will set the tax
rate to maximize revenue (at the top of the Laffer curve).
w Given R = tQ* = (at-bt2)(c)/(b+c), the revenue maximizing tax can be
found by differentiating R with respect to t and setting the result equal to
zero:
V. Overlapping Tax Bases: The Fiscal Commons Problem
w t* = a/2b which implies that Q* = (1/2)(ca/(b+c))
A. In cases in which government fiscal authority is decentralized, there can
be competition between levels of governments, and in some cases
governments at the same level, over a tax base.
w Market output under leviathan taxation is exactly half the untaxed market
quantity, see part a.
v. Now suppose that taxes are imposed by two independent tax-revenue
maximizing governments, in which case t = t1 +t2 and tax revenue for a
single government is tiQ* ( where Q* can be written as in part b).
a. The problem of over using a given tax base is a fiscal externality problem is
similar to the fiscal commons problem for expenditures outlined above, but
in this case generates over taxation rather than over supply of services
b. (Of course, both phenomena may occur with the same federal government.)
c. The common tax base problem is one possible rational choice explanation
for taxation beyond the level that maximizes revenue in a Laffer Curve
diagram (Flowers, 1988).
w For government 1 this is simply
w R = t1Q* = t1 (a-bt)(c)/(b+c) = (a t1 - bt12 - bt1t2)(c)/(b+c)
w Differentiating with respect to t1 , setting the result equal to zero, and
solving for t1*, produces the best reply function for government 1:
B. Consider the case in which excise taxes are imposed by two tax revenue
maximizing governments on the same tax base (product or service
market).
i. Suppose that the demand curve for this market is: QD = a - bP and the
supply curve is QS = cP, with QD(P*) = QS(P*) in the pretax
equilibrium.
w t1* = (a-bt2)/2b
w A similar function can be derived for the second government:
w t2* = (a-bt1)/2b
vi. At the Nash equilibrium, both governments will be on their best reply
functions.
w In the absence of an excise tax, the market clearing price would have
equated supply and demand: cp = a - bP , which implies that
w Solving for the symmetric case, allows the Nash equilibrium taxes to be
characterized: ti** = a/3b
w P* = a/(b+c) and Q* = cP* = ca/(b+c)
ii. In the case in which an excise tax of amount t is imposed, the condition
for market clearing price(s) is QD(Pc*) = QS(Pc*-t) or c(Pc-t) = a - bPc.
iii. A bit of algebra allows the consumer and supplier price, market
output, and tax revenue to be determined:
w This implies a combined tax of t= a/3b +a/3 = 2a/3b at the Nash
equilibrium.
w Note that this is higher than the revenue maximizing tax found in part
c, (2/3)(a/b) > (1/2)(a/b).
vii. Two leviathan governments that rely on the same tax base would
jointly impose tax rates that are beyond the revenue maximum of a
Laffer curve.
w Pc* = (a+ct)/(b+c) ; Ps* = (a+ct)/(b+c) - t = (a-bt)/(a+b);
w Q* = (a-bt)(c)/(b+c) ; R = tQ* = (at-bt2 )(c)/(b+c)
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EC741 Public Economics Handout 12: Fiscal and Regulatory Relationships Among Governments
{ Otherwise "public consumers" will vote with their feet and move to
other places that provide better value for their tax dollars (taking "their
tax bases" with them).
C. Students should work through the duopoly taxation problem as an
exercise.
{ What happens if the number of governments is N rather than 2?
{ Is this a more plausible scenario for democratic or autocratic
governments? Explain.
v. Intergovernmental competition does not always work as well as
Tiebout suggests, but this idea has informed a good deal of discussion
about the desirability of decentralizing the provision of services.
VI. Intergovernmental Competition: the Tiebout Model
B. Tiebout's model provides one of the strongest arguments in support of
decentralized governance.
A. Charles Tiebout (1954) pointed out that intergovernmental competition
between local governments can be very similar to competition between
firms in competitive markets.
w Decentralizing the provision of local services potentially allows voters to
get just what they want from goverment--no more and no less.
w That is to say, intergovernmental competition can generate patterns of local
public services and taxes that are Pareto efficient.
C. Although Tiebout may be a reasonable first approximation for
competition between local governments (and condo associations) within
a metropolitan area, clearly there are limits to its applicability--just as
there are limits to the applicability of his theory of perfect competition
in ordinary markets.
i. How sensitive are the Tiebout results to the assumptions?
i. Tiebout uses migration and changes in local tax bases to characterize a
perfectly competitive version of intergovernmental competition at
state and local levels.
a. He assumes that moving from one community to another is costless and
motivated entirely by differences in local public services and taxes.
b. He also assumes that competition for residents produces a wide range of
fiscal packages to choose from.
c. In this model, "tax and service competition" can be very similar to "price and
quality competition" in private competitive markets.
a. Clearly, the cost of moving between governments is not trivial, and tends to
vary with the level of government.
{ Does this imply that none of the predictions will hold up?
b. Or is there enough mobility into and out of communities within many
regions to put competitive pressure on local governments?
{ A large number of persons are always moving for other reasons and may
choose communities in large part for the combination of services and
taxes offered.
ii. In the limit, "voting with one's feet" produces a competitive
equilibrium among communities in which:
a. Each community provides its bundle of public services at least cost.
b. Every community is ideally sized to produce its bundle of services.
c. Each community's residents are "homogeneous" in their demand for local
public services.
d. Each voter-resident pays the marginal cost of his own services.
ii. Economies of scale or networks may reduce the number of
competing "town-firms" that can be sustained in a "Tiebout world" in
a manner that reduces the range of choice available to
voter-taxpayer-consumers.
iii. Such tax and service combinations meet the Lindalh conditions for
efficient provision of public services (as well as the Samuelsonian
ones).
iv. Note that this process does not require an effective political system to
achieve Pareto efficient results, only very mobile tax payers who can
take their part of the tax base with them.
{ The menu of government services that voter-taxpayer-consumers can
choose from may be more limited than the Tiebout model implies.
{ The effect of economies of scale parallel those in the microeconomic
analysis of perfect competition vs. monopolistic competition, oligopoly,
and monopoly.
{ In such cases, local politics will again be an important determinant of
citizen welfare.
{ In order to tax mobile resources, communities (towns, states, and
countries) have to provide services commensurate with their tax costs.
iii. The existence of intergovernmental externalities may also imply that
some services are under provided locally and others are over provided.
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EC741 Public Economics Handout 12: Fiscal and Regulatory Relationships Among Governments
a. The logic closely parallels our earlier analysis of externalities between
individuals and/or firms.
{ NIMBY problems may also emerge.
{ Transfer programs may be underprovided.
b. Solving externality and public goods problems may require "treaties-Coasian
contracts" or "interventions by other levels of government."
i. Consider the case of regulations and taxes that affect pollution within a
state.
ii. A community's regulations tend to affect the behavior of firms and
consumers who produce effluents, but only those that live in the
territory governed by the local government are directly affected by its
regulation.
iii. By affecting the level of externalities (or in some cases by producing
local public services) local governments produce benefits or impose
costs on persons living in other communities.
D. The existence of economies of scale and externalities provide an
economic rationale for federal systems with several "levels" of
government with responsibilities for providing services in different
sized jurisdictions.
{ For example, the more stringent a community's regulations are, the less
likely it is that effluents are emitted in a way that affects other
communities.
{ If Tiebout worked perfectly, it would imply that an efficient federal
government would be composed largely of local governments with a very
small central government with the sole task of guaranteeing citizen
mobility among communities.
{ (Explain why)
C. The local nature of politics implies that the government of one territory
is not likely to take account of the spillove costs or benefits that it
imposes on neighboring territories.
VII. Externalities and Regional Governments
D. For example, a "race to the bottom" may emerge if towns compete to
attract (polluting) industry (and tax base) by lowering environmental
regulations to attract firms to their communities.
i. A 3x3 game matrix can be used to illustrate the problem (see below).
A. All levels of governments can address externality problems through the
measures previously discussed: civil law, direct regulation, taxation and
subsidization, tradable permits etc.
i. However, there are limits to every government’s ability to solve an
externality, in the sense of limiting them to Pareto efficient levels.
ii. Some externalities are too broad to be handled by a single government.
The Race to the Bottom Dilemma
{ Regional environmental externalities often arise from the use of air and
water systems as a methods of disposing of undesirable substances
(pollution).
{ Global warming is partly a worldwide externality problem and there is not
world government.
Community B's environmental Regulations
weak
moderate
strong
A,B
A,B
A,B
weak
6,6
8,4
9,2
moderate
4,8
7,7
8,5
strong
2,9
5,8
6,6
A's env regs
iii. It also bears noting that governmental reglatory and tax policies
generate externalities, as in the fiscal commons problem above and in
the “race to the top” and “race to the bottom” cases developed in this
section.
iv. There are a wide variety of spillovers among communities and among
countries.
B. In many cases the existence of inter-state externalities implies that the
state regulations (or taxes) produce costs or benefits for other
communities.
ii. The payoffs can be thought of as (i) social surplus if governments are
benevolent social net benefit maximizers, (ii) votes if they are
competitors in democratic community elections, or (iii) as utility levels
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EC741 Public Economics Handout 12: Fiscal and Regulatory Relationships Among Governments
of the median voter if the strong form of the median voter theorem
holds in the two communities, states, or nations.
{ The payoffs have been constructed to illustrate the problem of interest.
{ Note that both communities have pure dominant strategies (weak
regulations).
{ The (weak, weak) cell is, consequently, the Nash equilibrium of the game.
The Race to the Top Dilemma
NIMBY
iii. The Nash equilibrium involves too little environmental regulation in
the sense that a Pareto superior move exists at the Nash equilibrium.
Community B's environmental Regulations
a. Note that there is a Pareto superior move (at the level of governments) from
(weak weak) to (moderate moderate) regulations.
b. The median voter of both these communities could potentially benefit by
coordinating their regulations and agreeing to adopt somewhat stronger
regulations.
weak
medium
strong
A,B
A,B
A,B
weak
6,6
4,8
2,9
medium
8,4
7,7
5,8
strong
9,2
8,5
6,6
A's env regs
iv. Note that this problem is very much like the free rider problem
associated with private efforts to adopt pollution reducing products,
and could be represented geometrically as well.
{ In such a diagram, the regulation would be set at the median voter's
optimal level, but there would be a spillover external benefit from the
regulation that affects neighboring communities.
{ (Try drawing such a diagram as an exercise. )
iv. Similar NIMBY-type regulatory problems also occur for locating
power plants, refineries, airports, shopping malls, and interstate
highways.
v. Such "political prisoner's dilemma games" are sometimes called
instances of "government failure" as opposed to "market failure.,"
because they arise because of the actions of government (rather than
inaction).
E. The opposite regulatory externality problem--over regulation--can also
occur.
i. A "race to the top" (NIMBY) tends to emerge if towns compete to
discourage polluting industries from locating in their communities by
enacting strict environmental regulations.
VIII. Inter-regional externality problems
{ NIMBY is an acronym for Not In My Back Yard.
{ For example, towns (etc.) may want to discourage land fills, incinerators,
water treatment plans, or nuclear waste facilities from locating in their
jurisdictions.
A. Some externality problems are "too large" to be dealt with by a single
local government, but are not reciprocal (symmetrical) in the sense of
the previous illustrations.
i. In some cases, the regulatory externality is "one way," because all of
the benefits of additional regulations or costs of effluents fall entirely
on persons outside the community.
ii. A 3x3 game matrix can be used to illustrate the problem (see below).
iii. The Nash equilibrium involves too much environmental regulation in
the sense that a Pareto superior move exists at the Nash equilibrium
{ Note that there is a Pareto superior move from (strong strong) to
(medium medium) regulations.
{ The median voters of both these communities could potentially benefit by
coordinating their regulations and agreeing to adopt somewhat weaker
regulations.
{ (Such might be the case in the tall smoke stack example discussed in class
if the wind always blows in one direction.)
ii. In such cases, community A’s regulations affect community B, but
community B’s regulations do not affect community A.
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EC741 Public Economics Handout 12: Fiscal and Regulatory Relationships Among Governments
ii. Electoral pressures may induce higher levels of government to adopt
policies that affect all the emissions sources and all of the benefits and
costs, rather than just a subset of them.
iii. Higher levels of government may also attempt to induce the local
government to coordinate their regulatory policies.
B. Such asymmetric cases, resemble the "race to the bottom" game,
because each community has an incentive to under-regulate the
externality in question.
i. Communities in asymmetric cases have no interest in regulating the
emission.
ii. There will again be unrealized gains from coordinating regulations
within the communities affected by the externalities, but they cannot be
realized by simply "trading regulations."
{ For example, governments state governments may mandate particular
local regulations or provide Pigovian subsidies or taxes that induce
communities to coordinate their regulatory decisions.
iv. They may also support agreements between communities by granting
authority to negotiate such agreements and by enforcing the
agreements in state or national court systems.
a. In such cases, the affected communities down wind or down stream will have
to compensate the community that can potentially regulate the emissions
source for the cost of doing so. (Some form of "side payment" will be
necessary.)
b. (Use a diagram and a game matrix to illustrate the nature of this regulatory
externality problem.)
C. Note that the externality arguments for centralization are not based on
the properties of the environmental or other externality problems, but
on defects in political decision making associate with addressing
those problems.
IX. Solutions to Regulatory Externality Problems
{ It is an attempt to address government rather than market failures.
A. One solution for regulatory externality problems is for the towns to
meet and work out a "Coasian" agreement to internalize the externality
problem.
i. In the cases of regulatory externalities, the communities can agree to
tighten up or relax the relevant environmental regulations.
ii. In the case of asymmetric externalities, communities downwind or
down stream can make cash payments or provide other services to the
community that controls the externality.
iii. Note that the such agreements are struck by governments rather
than all affected parties, and so are Pareto superior moves only at
the level of governments.
iv. (In the case of nation states, these Coasian contracts are called
treaties.)
D. There are many cases in which a l government cannot adopt Pareto
efficient regulations or service levels--even if it wants to--because part
of the problem is generated by persons or companies outside their
jurisdiction.
i. In international cases, the only possible solutions at present are
Coasian contracts (regional alliances or treaties).
w National may negotiate with each other and sign agreements to coordinate
policies or to create a "special use district" of the same "size" as the
externality.
w Such contracts are also possible within federal systems in which a subset of
local or regional governments agree to coordinate their policies.
w (Examples include airport and transit authorities, as with those between
NY, NJ and CN, or between VA, MD, and DC.
B. Another solution to such "regulatory externality" problems is to shift
policy responsibility to higher levels of government that can
"coordinate" the selection of environmental regulations or mandate
regulations across the communities of interest.
i. A county or state government should, in principle, take account of
county or statewide benefits.
ii. Most substantive international treaties and most international
organizations are products of Coasian contracts and most address
international externality problems of various kinds.
a. For example, in the various international environmental treaties, countries
agree to strengthen various environmental regulations to deal with an
international externality.
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EC741 Public Economics Handout 12: Fiscal and Regulatory Relationships Among Governments
b. Examples include international water commissions (US and Canada, Sweden
and Denmark) and international environmental treaties.
i. Services with global economies of scale should be provided by the
national government (national defense, macroeconomic policy,
redistribution)
ii. Services with that require relatively large service areas or numbers of
customers should be produced by state governments. (regional
highways, higher education, etc.)
iii. And services that can be effectively provided in relatively small service
areas or for relatively small customer bases should be provided by local
governments. (police and fire protection, elementary education, local
roads, sanitation services etc.)
E. International organizations rarely have coercive authority and so rarely
can impose solutions, but they can serve as a forum for working out
Coasian contracts.
i. Adjacent countries may ask states to regulate "county externalities,"
states form a treaty organization that makes recommendations about
“international” regulatory externalities.
ii. In Europe the regulation of many international externalities is
coordinated by the European Community.
{ (Note that the simple production-based arguments imply that particular
services should be provided by only a single level of government.)
a. Note that this solution is of limited value for international regulation and
public good problems because there are no world or continental
governments.
iv. Addressing problems of intergovernmental externalities and
economies of scale will require governments with larger jurisdictions
than those that provide local fire protection.
{ The results of Coasian contracts can be highly imperfect (relative to Pareto
optimality) in international settings. Discuss some of these.
X. The Economic Logic of Assigning Fiscal Responsibilities to
Different Levels of Government
$/G
A. The Tiebout case for decentralization suggests that services should be
provide by government's with the smallest jurisdictions (territories)
sufficient to realize all economies of scale for the service of interest.
Losses from Cenralized Mandates of Uniform Provision
of Local Public Services
Reduced NSB = a' + b' +c'
a. Oates (1972) develops this point more formally with his decentralization
theorem.
b. The EU adopts this idea with its "subsidiarity principle."
MBal
B. The externality and commons arguments reach similar conclusions.
Responsibility for “internalizing” externalities should be placed at the
smallest governmental level large enough to address the externality.
MBbob
c'
a. As noted above there are a variety of policy solutions for commons and
externaltity problems and a variety methods through which such solutions
can be chosen.
b. However, the best match between local demands and policies occurs in
decentralized systems.
c. See Ostrom (1990)
a'
c'
MC
b'
MBcathy
G*c
G*b
Qcentral
G*a
Q of governmetnt Service
(G )
C. The optimal size of governmental units (territories) that provide
particular services can be analyzed by studying economies of scale in
producing the services of interest..
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EC741 Public Economics Handout 12: Fiscal and Regulatory Relationships Among Governments
D. Wallace Oates (1972) argues that if policy or service X has an effect on
region Z, then the whole region should be managed by one government.
ii. In this case, there is a conflict (tradeoff) between avoiding Nimby and
"race to the bottom" problems, and benefiting from decentralization.
a. (Use two community SMB curves facing the same MC to show the losses
from uniform rules that address local environmental problems.)
i. Similarly, it can be argued that the "service district" (regional governed)
should be large enough to realize all economies of scale in producing
the service of interest.
iii. In cases in which the subjective costs and benefits of externalities vary
among communities, the level of government that can best handle the
externality problems is not always clear.
a. For example, some forms of education, police services, and environmental
regulation have only local effects.
b. The Oates-Tiebout analysis suggests that responsibilities for those services
should be local rather than state or national.
c. (Variety is good in the Oates-Tiebout framework.)
d. (Would fiscal equalization make sense in this framework? Discuss.)
B. These production and externality-based economic arguments, however,
neglect the advantages of variation in the services provided and also the
political costs associated with larger regional governments with greater
monopoly power.
i. There are political costs associated with merging quite different areas
into a single metropolitan area.
ii. On the other hand, other services tend to have regional effects as with
commuter networks, other forms of air and water pollution, and some
forms of police authority.
iii. Large--but not national--externality problems, such as lake or river
water pollution can be best addressed by state government or regional
consortiums of states.
iv. There are evidently great economies of scale in military force, which
suggest that national governments should have responsibility for this
service.
a. The community becomes more heterogeneous.
b. Monitoring costs tend to increase.
c. Each voter has a smaller effect on service levels through his locational choice
and voting behavior.
d. Competition tends to fall as the number of government service packages
diminishes.
w (Indeed, come "community mergers" may be just cartelizing behavior by
local politicians who attempt to escape from competitive pressures.)
w Similarly, insofar as the advantages of free trade zones increase with size, so
the national government should have responsibility for maintaining free
trade within the nation.
ii. It also bears noting that carefully assigning fiscal responsibilities to
specific levels of government is only one method of addressing these
kinds of problems.
a. Other solutions also exist, as noted in our previous analysis of solutions to
externality problems.
b. One can also use mandates and Pigovian subsidies and taxes (conditional
grants) to address intergovernmental externality and public goods problems.
c. The federal structure can also be left a bit open ended so that communities
and states can form "consortiums" or "regional authorities" to address
regional interests. (Treaties or Coasian Contracts).
XI. Political and Economic considerations when assigning or
revising responsibilities among governments.
A. Centralization has both economic and political costs.
i. Centralization often implies that environmental regulations that address
local problems will (usually) become uniform among the communities,
which tends to be inefficient if "average" preferences for
environmental quality differs among communities.
C. The best (utilitarian or contractarian) assignment of authority for
providing services to specific levels of government (should) take
account of both economic and political costs.
a. If communities differ in their demand for environmental quality because
their tastes or income differ then a uniform regulation will tend to generate
fewer net benefits for the state than a pattern of regulations that reflect
differences in demand.
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EC741 Public Economics Handout 12: Fiscal and Regulatory Relationships Among Governments
ii. Differences in the bargaining power and interests among participating
governments is likely to affect the distribution of fiscal and regulatory
authority adopted.
D. It bears noting, however, that in practice the degree of decentralization
that occurs within a polity is determined by constitutional and
quasi-constitutional negotiations rather than by utilitarian philosophers
or economists.
C. In Practice, a good deal of asymmetry is observed within federal and
confederal systems.
i. For example, in Spain, Navarra and the Basque communities have
formal tax and expenditure powers beyond those of the other
"autonomous communities."
XII. Endogenous Decentralization and Asymmetric Federalism
A. Most economic models of federalism assume that each government at a
given level has the same authority to make fiscal and regulatory
decisions. However, the assumption of uniform jurisdictional size and
power is not completely accurate.
i. For example, we observe significant differences in physical size,
population, income, and political representation for state and local
governments.
{ Galicia and Catalonia have special authority over education, language, and
culture.
{ In Canada, Quebec has special powers to encourage the use of the
French language and protect the French-Canadian culture.
{ In the United Kingdom, the Scottish Parliament has significantly more
policy-making authority than the Welsh Parliament.
{ In the United States, Indian reservations have their own specific taxing
and regulatory authority that differ from those of ordinary state
governments.
{ California, the most populous state, has unique powers of environmental
regulation.
{ In China, Hong Kong has been granted unique legal and political
institutions: "one country, two systems."
a. In the United States, California is physically the third largest state with 11%
of the citizens, whereas Wyoming, the sixth largest state includes less than
1% of the U. S. population.
b. Requejo (1996) notes that New South Wales includes 35% of the population
of Australia, whereas Tasmania includes less than 3%. North Rhine Westfalia
includes some 21% of the population of Germany, whereas Bremen includes
less than 1% of the population.
c. Uttar Pradesh includes 16% of the population of India, whereas Sikkim
includes less than a twentieth of one percent.
ii. Large cities in many countries often have powers of taxation and
regulation that smaller cities lack or rarely use.
ii. That population and population densities vary so widely implies that
demands for local services also tend to vary widely among these
regional governments and, moreover, implies that political power
within their respective democratic central governments is also likely to
vary widely by state, lander, and province.
{ New York City and Washington D. C. have their own income and sales
taxes.
iii. Asymmetries are also common among the members of large
international organizations.
{ In the European Union, some members retain more autonomy than
others inasmuch as they have opted out of or delayed membership in the
menu of treaties that define the responsibilities of affiliated countries.
{ The responsibilities of members of the United Nations with respect to
military armaments, human rights, and environmental regulations are
similarly defined through a series of treaties with quite different
signatories.
{ Different nations formally retain different degrees of autonomy both
within and without these very decentralized confederations.
B. That regional interests and bargaining power vary is important for fiscal
federalism, because national constitutions do not fully specify the degree
of decentralization within a nation at any single point in time or through
time.
i. Rather, the degree of decentralization is determined by a series of
political bargains within and between national and regional legislatures
in which both the details of policy and the powers to make policies are
negotiated and renegotiated through time.
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EC741 Public Economics Handout 12: Fiscal and Regulatory Relationships Among Governments
a. Individuals prefer to work for firms that are close to the rail lines, and
consumers prefer to live and shop at stores near the rail lines—other things
being equal—because the net of transport real wages are higher and net of
transport prices are lower along the rail lines.
b. This increases net benefits and profits for consumers and firms located near
the rail lines.
c. Moreover, rental revenue from the right of ways allows the favored city to
reduce other tax rates within the city.
D. Service differences across communities may also emerge in both
decentralized and unified states, because communities may have unequal
influence over the decisions of the central government because of
differences in population, political heterogeneity, history, or size.
i. For example, equal representation by population often implies unequal
representation by regions or economic interests, and vice versa.
{ In the US, some states have far more influence in the House than in the
Senate, and these differences have been shown to influence the pattern of
intergovernmental grants
iii. Given these economic advantages, persons and firms from within the
favored city and throughout the country of interest will attempt to
relocate near to the rail lines of the favored city.
ii. Unequal influence within the central government implies that central
government policies will often favor some regions or communities over
others.
{ In principle, the favored city continues expanding its rail network and
attracting tax base up to the point where the marginal increase in revenue
and tax base generated by an extra kilometer of new right of way equals
the marginal cost of the right of way less any loss in tax base generated by
investor fears concerning the use of eminent domain—or until no private
firm is willing to expand its rail network because traffic densities are too
low to recover its costs. The latter, of course, expands outward from the
city center as immigration of capital and labor occurs.
{ Analysis of variation voting power has a long and distinguished history in
the public choice literature. (See for example: Mueller, 1989.)
{ However, this form of asymmetry is not the same as that analyzed here in
which regional governments acquire different degrees of local
policy-making authority.
E. Asymmetric federalism exists whenever governments at the same
level of geographic responsibility—towns, counties, cities, or
states—have different regulatory and fiscal powers.
iv. Although there is a limit to the urban growth encouraged by this city’s
unique power of eminent domain, the favored city becomes an
important commercial and cultural center well before this limit is
reached. Its internal market and population expands.
{ Such differences in policy authorities create a "supply-side" source of
variation in government services, regulations, and taxes in addition to the
standard demand-side variation in local demand stressed in models of
local fiscal competition.
{ Specialization increases; and wages and profits increase as productivity
rise.
{ Other cities that have to rely entirely upon private provision of rail
services falter, because holdout problems make assembling long right of
ways very difficult—indeed intractable—for private firms acting alone.
{ The more autonomous city grows and prospers—while other similar
cities that would have copied the strategy of the favored city are legally
unable to do so.
F. For example, consider the case in which only a single city is granted
authority to use eminent domain to produce “right of ways” for light
rail transport services.
i. Suppose that the favored city sells or rents the right of ways to private
railroad companies.
a. This provides the city with a unique source of revenue and also a unique
economic advantage.
b. Both effects allow the more autonomous government to provide a more
attractive fiscal and economic environment for its residents than possible for
otherwise similar governments.
v. Other local fiscal and regulatory "privileges" can have similar effects,
insofar as the additional authority allows favored governments to
provide a more attractive fiscal package than legally possible for other
similar governments.
G. Asymmetric federalism may take a variety of institutional forms.
i. Specific asymmetries may be created by a nation’s constitution by
assigning different areas of competency to various regions of the
country.
ii. Light rail has the effect of reducing transport costs to city apartments,
shops, and factories that operate in an otherwise competitive market.
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EC741 Public Economics Handout 12: Fiscal and Regulatory Relationships Among Governments
ii. Alternatively, the constitution may allow the possibility of alternative
internal arrangements that allow the formation of many levels and
combinations of fiscal authority.
{
H. Surprisingly little research has been done asymmetric forms of
federalism.
i. Tiebout, 1956, and Oates, 1972, pioneered the economic analysis of
fiscal federalism and intergovernmental relationships.
a. For example, a national constitution may simply allow states to organize
themselves into various subnational organizations of states, cities, or
counties.
b. An international treaty organization may allow a subset of member states to
pursue their own interests within the terms of the treaty.
a. Inman and Rubinfeld (1997) provide a nice survey of issues in subsequent
literature.
b. Molander (2004) provide a more international review of fiscal federalism in
unitary states.
c. Qian and Weingast (1997) elaborate the role that federalism can play in
solving various commitment and information problems.
iii. This possibility allows a range of federal structures that is more
complex than normally analyzed by economists. However, it is clear
that that many internal organizational structures tend to produce
asymmetric forms of fiscal federalism.
ii. None of these papers or books includes any reference or comments on
asymmetric forms of federalism.
a. The figure below illustrates one such internal structure.
If we interpret the interregional government as another level of centralized
control, it is clear that local government 1 retains more autonomy than local
governments 2 and 3, because it is not bound by the decisions of the
regional government, if the regional government is not granted exclusive
areas of competency.
a. Requejo (1996) analyses some general features of existing asymmetries within
modern states.
b. Congleton, Bacarria, and Kyriacou (2003) analyze the political foundations of
asymmetric distribution of authority within nation states and international
organizations.
Internal Institutional Asymmetry
within
Federal Governments
Central
Government
Inter Regional
Organization
Regional
Government 1
Regional
Government 2
Regional
Government 3
14